COST CONCEPTS & CLASSIFICATIONS
Lecture Notes
General cost classifications: Our initial focus is on
manufacturing companies since their basic activities
include most of the activities found in other types of
business organizations. Nonetheless, many of the concepts
developed in this lesson apply to diverse organizations.
A.Classifications of manufacturing costs (e.g., direct
materials, direct labor, and manufacturing overhead):
i. Direct materials − Raw materials that
become an integral part of the finished
product and whose costs can be conveniently
traced to it.
ii. Direct labor − Labor costs that can be easily
traced to individual units of product (also
called touch labor).
iii. Manufacturing overhead − Includes all
manufacturing costs except direct materials
and direct labor. These costs cannot be easily
traced to specific units produced (also called
indirect manufacturing cost, factory overhead,
and factory burden).
1. Includes indirect materials that are part of
the finished product, but that cannot be
easily traced to it.
2. Includes indirect labor costs that cannot be
conveniently traced to the creation of
products.
3. Other examples of manufacturing overhead
include: maintenance and repairs on
production equipment, heat and light,
property taxes, depreciation and insurance
on manufacturing facilities, etc.
B.Classifications of non-manufacturing costs (also
called selling and administrative costs).
i. Selling costs – Includes all costs necessary to
secure customer orders and get the finished
product into the hands of the customer.
ii. Administrative costs – Includes all costs
associated with the general management of an
organization.
C.Product costs versus period costs
i. Product costs (also called inventoriable
costs) – Includes all the costs that are
involved in acquiring or making a product.
More specifically, it includes direct materials,
direct labor, and manufacturing overhead.
1. Product costs are expensed in the income
statement when the products are sold.
ii. Period costs – Includes all marketing or
selling costs and administrative costs.
1. These costs are expensed in the income
statement in the period incurred.
D.Prime costs and conversion costs
i. Prime cost − Direct materials cost plus direct
labor cost.
ii. Conversion cost – Direct labor cost plus
manufacturing overhead costs.
Cost classifications on financial statements
E. Merchandising vs. manufacturing companies
i. Merchandising companies − Purchase
finished goods from suppliers for resale to
customers.
ii. Manufacturing companies − Purchase raw
materials from suppliers and produce and sell
finished goods to customers.
F. The balance sheet: merchandising vs.
manufacturing companies
i. Merchandising companies do not have to
distinguish between raw materials, work in
process, and finished goods. They report one
inventory number on their balance sheet
labeled merchandise inventory.
ii. Manufacturing companies report three types
of inventory in one consolidated number on
their balance sheets.
1. Raw materials – The materials used to
make the product.
2. Work in process − Consists of units of
product that are partially complete, but will
require further work to be saleable to
customers.
3. Finished goods − Consists of units of
product that have been completed, but not
yet sold to customers.
G.The income statement: merchandising vs.
manufacturing companies
i. Merchandising companies calculate cost of
goods sold as:
COGS = BMI + Purchases – EMI
ii. Manufacturing companies calculate cost of
goods sold as:
COGS = BFGI + COGM – EFGI
H.The schedule of cost of goods manufactured
i. This schedule contains the three elements of
costs mentioned previously, namely direct
materials, direct labor, and manufacturing
overhead.
ii. It calculates the cost of raw material, direct
labor, and manufacturing overhead used in
production.
iii. It calculates the manufacturing costs
associated with goods that were finished
during the period.
Product cost flows
iv. To create a schedule of cost of goods
manufactured, as well as a balance sheet and
income statement, it is important to
understand the flow of product costs:
1. Raw material purchases made during the
period are added to beginning raw materials
inventory. The ending raw materials
inventory is deducted to arrive at the raw
materials used in production.
a. As items are removed from raw
materials inventory and placed into the
production process, they are called
direct materials.
2. Direct labor and manufacturing overhead
(also called conversion costs) used in
production are added to direct materials to
arrive at total manufacturing costs.
3. Total manufacturing costs are added to the
beginning work in process to arrive at total
work in process.
4. The ending work in process inventory is
deducted from the total work in process for
the period to arrive at the cost of goods
manufactured.
5. The cost of goods manufactured is added to
the beginning finished goods inventory to
arrive at cost of goods available for sale.
The ending finished goods inventory is
deducted from this figure to arrive at cost of
goods sold.
6. All raw materials, work in process, and
unsold finished goods at the end of the
period are shown as inventoriable costs in
the asset section of the balance sheet.
7. As finished goods are sold, their costs are
transferred to cost of goods sold in the
income statement.
8. Selling and administrative expenses are not
involved in making the product; therefore,
they are treated as period costs and reported
in the income statement for the period the
cost is incurred.
II. Cost classifications for predicting cost behavior
A.Cost behavior refers to how a cost will react to
changes in the level of activity within the relevant
range. The most commonly used classifications of cost
behavior are variable and fixed costs:
i. Variable cost − A cost that varies, in total, in
direct proportion to changes in the level of
activity. However, variable cost per unit is
constant.
ii. Fixed cost − A cost that remains constant, in
total, regardless of changes in the level of the
activity. However, if expressed on a per unit
basis, the average fixed cost per unit varies
inversely with changes in activity.
Cost classifications for assigning costs to cost objects
B.Cost object − Anything for which cost data are desired
including products, customers, jobs, organizational
subunits, etc. For purposes of assigning costs to cost
objects costs are classified two ways:
i. Direct costs − Costs that can be easily and
conveniently traced to a specified cost object.
ii. Indirect costs − Costs that cannot be easily
and conveniently traced to a specified cost
object.
1. Common costs − Indirect costs incurred to
support a number of cost objects. These
costs cannot be traced to any individual cost
object.
Cost classifications for decision making
C.It is important to realize that every decision involves a
choice between at least two alternatives. The goal of
making decisions is to identify those costs that are
either relevant or irrelevant to the decision. To make
decisions, it is essential to have a grasp on three
concepts:
i. Differential costs (or incremental costs) − A
difference in cost between any two
alternatives (a difference in revenue between
two alternatives is called differential
revenue).
1. Differential costs can be either fixed or
variable.
ii. Opportunity cost − The potential benefit that
is given up when one alternative is selected
over another.
1. These costs are not usually entered into the
accounting records of an organization, but
must be explicitly considered in all
decisions.
iii. Sunk cost − A cost that has already been
incurred and that cannot be changed now or in
the future.
